Tontines: Might Retirees Prefer Noninsured Annuities?
Tontines, a nearly-extinct financial device invented centuries ago, are receiving fresh attention as a tool for retirement income. We do mean fresh – modern tontines envisioned by economists today have evolved since the tontines of yestercentury.
Tontines were originally used by nations to finance wars against other nations. The government would offer to borrow money from the citizenry with a promise to pay an interest rate for the rest of each tontine shareowner’s life (or the life of another person that a shareowner might nominate, often a young child). Later, private insurance companies began to issue a product called “tontine insurance” with similar characteristics. The products had become quite popular by the end of the 19th century. Sadly, the products fell victim to misappropriation and fraud on the part of their issuers. Regulators in several countries banned certain troubling aspects of the “tontine insurance” products being sold at the time, and they quickly became extinct… well, almost.
Tontines persisted on a small scale in France. A few public pension systems, such in Sweden and the U.S. state of Wisconsin, operate with tontine-like characteristics. So, too, does the CREF variable annuity that has been sold within the U.S. since 1952. More recently, the European Union moved to allow tontines. South Africa has followed suit beginning with the informal economy, Australia has been considering tontine-like group self-annuitization schemes, and Canada has likewise been considering tontine arrangements.
Financial regulation is now far stronger than it was over a century ago when bad-acting tontine issuers met their downfall. Recordkeeping, custody, and auditing systems have been created and improved to prevent the misappropriation of retirement assets. Even so, the wheels of financial regulation often move slowly. Regulatory hurdles to these products remain in the U.S., U.K., and many other countries. Still, the global trend is gradually moving toward acceptance, and for good reason – tontines represent a useful and highly efficient approach in addressing the global retirement problem.
The retiree’s problem
Post-retirement portfolio decumulation presents one of the thorniest challenges in finance. The problem is longevity risk – the risk of outliving the portfolio’s assets over a highly uncertain lifespan. The challenge is to economically deliver an income stream that reliably lasts for the rest of a retiree’s life, no matter how long. This is difficult even for professionals at the institutional level as the sad state of so many defaulted and endangered pension plans – and even social security programs – will attest. The challenge is arguably even harder for individual retirees, who have but one life and therefore one chance to get it right in the face of much uncertainty.
Unfortunately, few tools exist for managing longevity risk. One approach is to manage it oneself, typically by investing and withdrawing conservatively to guard against adverse markets or a long life. Another approach is to transfer the risk to an insurance company by purchasing a guaranteed life annuity. These approaches, each with benefits and drawbacks, are not mutually exclusive, and many advisors recommend a blended approach in which retirees utilize both to one degree or another.
Tontines themselves represent a blended approach – a kind of noninsured annuity that many retirees might find attractive.
Lifetime uncertainty and lifetime income
Insurers are able to guarantee lifetime income by 1) relying on the power of mortality risk pooling to greatly diversify the risk, 2) setting aside reserves to guard against undesirable outcomes, and 3) charging an additional markup for other expenses and profits.
Pooling many lives together diversifies risk because although it is highly uncertain how long any one person will live (called idiosyncratic risk), it is far less uncertain how long a large number of people will live in aggregate. With a large pool, substantially all of the idiosyncratic risk component can be effectively diversified away.
Insurers also bear the risk that the entire population lives longer than expected (called systematic risk), which is not diversifiable. Undiversified risk is quantified and priced, with a portion set aside as a risk reserve. An additional markup may also be priced in as a profit margin.
The retiree’s perspective
For retirees, the idiosyncratic component is by far the most worrisome – Yikes, will I live another 10 years… or another 40 years?
The systematic component is typically much less worrisome – Might the life expectancy of my age cohort in aggregate turn out to be longer than the experts think?
What if there was a way for retirees to inexpensively diversify away the worrisome idiosyncratic risk and retain the less-worrisome systematic risk, avoiding all insurance costs? Enter tontines.
What is a modern tontine?
Think of a modern tontine as a collective investment pool that pays out according to some pre-determined formula – as a lifetime annuity, for example. No insurance is involved whatsoever. The twist is that as members die, their share of the pool is forfeited and redistributed fairly to the remaining surviving members. Thus, members receive not only their share of investment gains and losses, but also a share of the final account balances of those who predecease them.
In this way, tontines offer a way for retirees to collectively self-pool their longevity risk without involving an insurer. This diversifies away idiosyncratic risk every bit as effectively as an insured annuity. Tontine members still bear systematic risk in that payouts over time could end up being somewhat lower (or higher) than anticipated if the membership lives longer (or shorter) on average than expected.
As with insured income annuities, tontine investments would be irrevocable. It is therefore unlikely that anyone would want to put their entire savings into one. But even a partial allocation would help mitigate longevity risk.
Of course, the redistribution of forfeited account balances should be done fairly such that no member is advantaged or disadvantaged. Ideally, the method of redistribution should be easy to understand and readily perceived by experts and laypersons alike as fair. A useful analogy is the parallel between fair game design and fair tontine design.
For example, a game is considered fair when the expected return to each player is zero each time that the game is played. Casino games are not fair since the odds favor the house (which is an active player in every casino game). In fair games, however, no player – not even the house – has any advantage or disadvantage.
The concept is similar in a fair tontine. For each member, the expected value of forfeitures gained while living is designed to equal the expected value of forfeitures lost at death.
At this point you might be thinking, “Wait… if the expected net value of these forfeiture distributions is zero, why invest in a tontine?” The answer is that the tontine changes the conditional distribution of outcomes in a very useful way. By participating in a tontine, those who die early receive less and those who live longer receive more. This is exactly what retirees who are dependent on their retirement savings need.
Because tontines come without any sort of guarantee, their payouts cannot be fixed but rather will vary depending on investment performance and the mortality experience of the membership pool. Those that desire smoother payouts would invest their tontine assets more conservatively, perhaps even in Treasury bonds with laddered maturities to help reduce payout volatility to a minimum.
Tontines could offer a wide variety of payout options. Examples include a life annuity, a deferred life annuity, a term annuity, or a simple lump-sum term investment. Payouts could be based on the life of an individual member or the last-to-die of a couple.
Note that because they make no guaranteed promises, tontines can never become underfunded. No promises means no underfunded liabilities – ever.
Unlike annuities, tontine pricing and accounting can be completely transparent. Fees would be clearly disclosed upfront and could be quite low, especially if the tontine assets were invested passively. All cash flows that affect a member’s account could be disclosed on periodic account statements and easily audited. Furthermore, some suggest that tontines could operate on blockchain technology, providing an immutable record of every transaction.
When most people think of a tontine, they think of a particular investment pool packaged with a particular payout formula. However, fairly-designed tontines are much more versatile than this. For example, fair tontine brokerage accounts could be developed in which members are different ages and genders, invest different amounts at different times, select their own investments, trade however they wish, and select from a wide variety of different payout options.
It may seem puzzling that an aggressive investor is not disadvantaged by being in a pool full of conservative investors. Wouldn’t he be better off if the other members likewise invested aggressively and died with larger balances? Counterintuitively, the answer is no. That is the beauty of fair tontines – like fair games, they are fair to all regardless of who else participates or how they participate (explained here).
Who might be interested in tontines?
Tontines might be of interest to:
Employers that wish to offer defined-benefit-like employee pension plans that can never become underfunded (tontine pensions)
Defined-contribution plan sponsors who wish to include a lifetime income option in their plans, while avoiding the fiduciary liability associated with selecting a guarantor
Investors who wish to increase investment return without increasing investment risk (and are willing to irrevocably give up a liquidity tradeoff)
Anyone seeking the assurance of lifetime income with greater transparency and at lower cost than with insurance products (albeit without a fixed guarantee)
Asset managers who wish to challenge insurance companies in the market for lifetime income
Public policymakers who wish to encourage participation in lifetime income solutions
Modern tontines represent an attractive solution in addressing the retirement income challenge. They offer a low-cost way to derive extra income without taking on additional investment risk. They provide the assurance of lifetime income in a way not possible with traditional investments. As a type of noninsured annuity, they efficiently diversify away idiosyncratic longevity risk, yet dispense with the overhead costs and opaque pricing associated with insured annuities.
Tontines do have drawbacks. Investments are irrevocable, account holders cannot withdraw freely however and whenever they wish, and payout levels are not guaranteed.
No single product represents the best of all worlds, but consumers can benefit by having an expanded set of choices. Tontines represent a highly useful alternative with unique benefits not otherwise available from traditional investment and annuity products. With a little help from policymakers and regulators to open the market, we expect modern tontines to flourish.